Private Equity For Coupon Clippers

In the quest for yield, it pays to search the obscure corners of the market. One long neglected niche: business development companies, or BDCs. These publicly traded private equity firms invest in and lend to small and midsize businesses and then pay out almost all their earnings as dividends to shareholders in much the way real estate investment trusts do.

BDCs were hit hard by the liquidity freeze during the financial crisis. But 2012 was a banner year for the group. AMERICAN CAPITAL (ACAS, 13), which has $118 billion in assets invested and under management, posted a total return of 79% and KCAP FINANCIAL (KCAP, 10), founded by James Kohlberg and his father, Jerome Kohlberg, of KKR fame, had a return of 63%.

The group is thriving now because they are able to borrow at low rates and lend, typically in the form of mezzanine and term loans, at higher rates. Moreover, their target market–companies with $5 million to $150 million in annual revenue–is full of creditworthy borrowers. Yet the BDCs’ chief competitors, the banks, are still apprehensive about lending to these firms.

This will be another good year for the BDCs, Fitch Ratings expects. They should benefit from pent-up M&A demand, since they both finance acquisitions and profit when companies they’ve invested in are bought out. They’re also likely to get a boost from the new Jumpstart Our Business Startups Act, which makes it easier for small companies to go public, thus providing another source of cash for paying back the BDCs.

At current prices BDC stocks offer yields ranging from around 7% to 11%. Like REITs, they are required to pay out at least 90% of their net interest income in the form of dividends. (Most distribute 98% to avoid corporate taxes.) Since BDC payouts are taxed as ordinary income at rates of up to 39.6% (and not as “qualified” dividends at a top rate of 20%), tax-deferred retirement accounts usually make the best home for these stocks.

Not, surprisingly, you’ll pay for BDCs’ hefty yields by taking on some risk. Like other private equity and venture capital firms, they invest in some companies that fail. And since they distribute most of their income each year, BDCs can’t smooth out their dividends, the way some big companies do. So, for example, MCG CAPITAL (MCGC, 4.6), which yields 11%, didn’t pay any dividends in 2009. American Capital, last year’s standout, almost went bankrupt in 2010, and its shares have yet to fully recover to their pre-financial-crisis peak.

To protect yourself, stick with those listed BDCs that came through the financial crisis relatively unscathed. While the following picks haven’t escaped volatility, they continued to pay dividends during the crisis and have relatively conservative management.

ARES CAPITAL (ARCC, 18) yielded an average of 15.8% in 2008 and 18.1% in 2009 as its stock price fell from $14 to $3. In 2010 it bought Allied Capital, a struggling BDC pioneer that had bet heavily on commercial real estate, in an all-stock deal valued at $648 million. Ares President Mike Arougheti told investors in a November conference call that he thinks big banks’ lending will continue to be constrained by stricter capital requirements from the Dodd-Frank Act and Basel III. “While the market environment for new investments is less favorable, the good news is that it’s been and continues to be very favorable for us to access capital as an issuer,” Arougheti said. Ares shares yield 8.6%.

Consider HERCULES TECHNOLOGY GROWTH CAPITAL (HTGC, 12) if you want a piece of the Silicon Valley action. Hercules invests in biotech, clean-tech and high-tech companies. Its loan portfolio includes northern California‘s Alphabet Energy, which produces electricity from energy waste; Nextwave Pharmaceuticals, which was acquired by Pfizer for $700 million in October; and cloud computing services provider Box.net. The company’s annual dividend yields have been high but inconsistent. The stock yielded an average of 13.6% in 2008 but only 8% in 2010 and 8.1% in 2011. Over the last five years the stock has had an average annual total return of 12%, and it currently yields 8.4%.

Despite considerable volatility, PROSPECT CAPITAL (PSEC, 11) stock has produced an average annual return of 8.2% over the last five years. The company, which lends to and invests in a variety of small companies, including Anchor Hocking and Totes?Isotoner, offers a yield of 11.7%.

TRIANGLE CAPITAL (TCAP, 27) specializes in lending subordinated debt to companies with between $10 million and $200 million in annual revenue. Since subordinated debt has less protection than senior, secured debt in bankruptcy proceedings, Triangle is able to charge higher, junk-bond rates to borrowers. It attempts to minimize the subordinated risk by looking for borrowers that have conservative capital structures, generate a steady stream of cash and are run by experienced managers with big ownership stakes. Triangle Capital yields 8% today.

If choosing a single BDC makes you nervous, you can buy E-TRACS WELLS FARGO BUSINESS DEVELOPMENT COMPANY INDEX ETN (BDCS, 26) . It tracks 26 BDCs and yields 6.9% but charges 0.85% in annual fees. Its big brother — E-TRACS 2xLEVERAGED LONG WELLS FARGO BUSINESS DEVELOPMENT COMPANY INDEX ETN (BDCL, 27) –tracks the same index and charges the same fees but uses double leverage to goose yields to 13.2%. These funds don’t have a long track record–they’ve been available only since May 2011. Still, they offer a more diversified way to dabble in BDCs.

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